Bonds in 2014

By Joel Dresang

As soundly as stocks performed in 2013, bonds overall struggled. The benchmark Barclays U.S. Aggregate bond index had a negative total return for the first time since 1999 and only the third time since 1976.

But investors should resist any reflex to abandon bonds.

Panicked by media reports on the demise of bonds, some investment clients have been inquiring about jumping ship and converting bonds to cash, says Bob Landaas, president of Landaas & Company. Bob’s advice: Don’t overreact.

In fact, the performance of bonds in 2013 offers lessons to investors. Among them:

Remember why you own bonds.

“I see some challenges in the bond market, but I don’t even own bonds to make money. I own them to keep out of trouble,” says Brian Kilb, chief operating officer and executive vice president at Landaas & Company.

Bonds serve as more stable, less volatile complements to stocks in portfolios. They generate some interest income but also offer relative protection for long-term investors.

“It is your safe money,” Bob Landaas says. “You’re concerned about the return of your money as well as the return on your money.”

Not all bonds are the same.

“It’s very unusual to have losses in the bond market over a calendar year, but that doesn’t mean that there aren’t areas of the bond market that could do pretty well,” says Marc Amateis, vice president at Landaas & Company.

For instance, some overseas bonds have potential, Marc says.

“Where countries have their financial houses in order, where they’re not running large deficits and they don’t have large debt, that usually leads to an increase in the credit rating of those bonds, which gives them a higher value, a higher price,” Marc says.

Marc also sees possibilities in municipal bonds: “Depending on your tax bracket, municipals might be a good place to look because you can get that tax savings. In addition, the valuations seem to be pretty reasonable.”

Don’t chase yield.

After recent years of higher-than-normal bond yields, investors have lost sight of the role of bonds and followed temptation to riskier securities.

“Be careful not to look just at yield and chase the biggest number you can find,” says Dave Sandstrom, vice president at Landaas & Company. “I see a lot of people looking for high-yield bonds and going into that area of the market. However, you have to remember the risk that’s associated with that. If you look back at 2008, high-yield lost over 25 percent.”

Watch durations.

The longer the duration of a bond, the more you’ll feel the value decline as interest rates rise from near-historic lows.

“Stay relatively short in duration,” Marc says. “That’s your protection against a rise in interest rates.”

At the same time, don’t go too short too fast, Bob says. Higher rates are inevitable, but they’re not imminent. Intermediate durations are a reasonable option in the meantime.

Interest rates and bond prices move in opposite directions.

The longer the duration of the bond, the greater the impact the rate change has.

Here’s the math:
Multiply the duration by the change in rate.

So if you have a bond fund of 30 years in average duration and interest rates go up half of a percentage point, the value of the fund drops by 15% (30 times 0.5). If the average duration is shorter – say five years, the value drops less – in this case, 2.5% (5 times 0.5).

It makes sense to steer away from long-term bonds for now – especially as the Federal Reserve begins to unwind its $85 billion monthly investments in longer-term debt.

But the Fed has stated repeatedly that it plans to keep short-term rates near zero at least into 2015. In addition, inflation is not yet pushing the 2% threshold at which the Fed says it will consider raising rates.

“Inflation doesn’t just show up on your doorstep one day,” Bob says. Three forces telegraph rising inflation – wages, commodity prices and production capacity utilization. So far, none of those three has rung an alarm for inflation.

That suggests a gradual rise in short-term rates, similar to the rate increases a decade ago, when investors benefited more from the yields of intermediate durations rather than abandoning bonds altogether for cash.

Though valued for their stability, bonds showed extraordinary explosiveness in mid-2013, spurred by Fed Chairman Ben Bernanke’s remarks in May about eventually easing monetary stimulus. The yield on the 10-year Treasury note, which was 1.6% at the beginning of May, jumped to 2.7% by early July and then to 3% in September, which is where it ended for the year.

Bondholders should brace for some volatility – though probably not as extreme – in 2014, Brian says.

“I think you’re going to have a lot of discussion about monetary policy, a lot of discussion about the potential for inflation. But I still think at the end of the day it’s going to be difficult to have bonds punished as much on an annual basis as they were in 2013,” Brian says. “I expect to do reasonably well in bonds for the low interest rate environment we’re in, but I expect some volatility along the way.”

Joel Dresang is vice president of communications at Landaas & Company.

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